Investor protection is a policy choice. To explain a policy choice, we look to political interests, political institutions, and political preferences. Tell us whether the influential decisionmakers win or lose from financial development and, say the political economists, we’ll tell you whether a nation will get strong or weak investor protection… When we don’t see finance developing, look for the polity’s dominant interest… So, as Rajan and Zingales (2003) show, elite incumbent industrial interests with local market power do not want financial development, because finance can propel competitors and erode the incumbents’ industrial position. The incumbents, with strong market positions, can finance themselves well enough, and seek to stifle upstarts by cutting off their blood supply: access to new finance. Perotti and von Thadden (2006) look less to elites than to democratic preferences. Their prototypical country is a European one whose middle class had its savings devastated in the interwar inflation. Their dominant interest is the median voter in, say, the 1960s, one lacking financial assets but with strong human capital, a voter who has little reason to support investor protection and some reason to oppose it: Financial markets are corrosive and bring about change. Such a median voter has reason to fear financial markets, which are likely to erode the current way of doing business and degrade the median voter’s human capital.
Roe (2003, 2006) looks at European social democracy and corporatism as affecting corporate governance thusly: If product market competition is weak in a nation, incumbent owners and incumbent labor have rents to split. If owners do not keep their ownership interests focused, they won’t capture those rents. They have little reason to support institutions that would strengthen financial markets, because they do not want them for themselves since they keep a focused ownership interest in the firm, so that when the supra-competitive spoils are divided, they get a good share of the pie.In the ensuing post-war decades in Europe, labor power made strong claims on firms’ cash flows… powerful claims that gave concentrated owners an advantage over dispersed owners in forming a countervailing coalition to keep more value in shareholder hands. Democratic nations with strong left power after World War II had governments less likely to support capital markets institutions, such as well-funded regulators or business courts, that would protect outside stockholders and bondholders. Nations that pursued strong labor protection (as evidenced by strong employment protection laws) had weaker financial markets.
Get the political economy configuration in place and the investor protection institutions will follow ― any origin has the tools to do so. If the political economy isn’t in place, then good investor-protection institutions, even if built, will degrade. Legal origins theorists have not, thus far, responded head-on to the political economy challenge
And what if the origins view is wrong and the political economy one right? If so, the technical institutions can only be effective if the economics and politics get the nation into the ballpark where financial markets are welcomed and functional. Technical fixes cannot and will not work if the polity is unsupportive of financial markets. And they will not work at all if the polity is hostile to financial markets. Many polities today are only wary, but many more were historically deeply hostile to finance. Today, a development agenda that focuses on the micro-institutions of finance and investor protection is more plausible than before. Moreover, even if the origins differences are real, the political economy view is that legal origin differences are minor in comparison to political economy differences.